Opinion: Is there an alternative to the Official Cash Rate tool that would work better for New Zealand?

By Winston Wade*

The present situation of low interest rates provides an ideal opportunity to review the use of the Official Cash Rate and to improve the tools available to the Reserve Bank to control the economy.

The proposal being suggested for debate is for the Reserve Bank to impose a levy (for the want of a better name) on interest at the retail level, rather than at the wholesale level with the OCR.

 Summarised below is brief list of:

- Some of the unfavourable aspects of the existing system.

- Discussion of some of the issues to be considered with a levy system.

- Discussion of the issues to be considered if the levy was extended to off-shore borrowing.  This would be of little effect at the moment with our low interest rates, but would become more relevant if our rates unilaterally increase.

Apart from inflation there are a number of other risks to the economy that need to be addressed:

1. New Zealand’s vulnerability arising from the high level of foreign debt. The high ratio of total foreign debt to Gross Domestic Product contains a credit availability risk in international credit markets; Greece is the prime example of what can occur.
2. Default by banks and other deposit takers.
3. NZ dollar exchange rate increasing in value against some currencies as the OCR increases.
4. The low savings rate in New Zealand means we have a shortage of capital for investment. We must borrow overseas or sell assets to make up the shortfall

Existing system

The Reserve Bank, in its role of controlling inflation within a certain band uses various monetary policy tolls. However, the principle tool is the setting of the “OCR” overnight cash rate or wholesale rate. The objective of setting a higher rate is for the higher rate to flow through to retail rates and thereby curb domestic demand, correcting an imbalance between the money supply and goods available.

The OCR has been quite successful in achieving the narrow target of having a low inflation rate and has prevented the high inflation associated with the late 1970s. But it does have some unintended effects.

Problems with the OCR as a tool of monetary policy.

The OCR is rather a crude tool that can have negative effects in parts of the economy. If the rate is changed it is difficult to quantify the effect and predict when the effect of such a change will take place.

An increase in the OCR in New Zealand can be slow to take effect because the number of borrowers who have fixed interest loans.

An increase in the OCR does little to dampen consumer demand financed through credit cards, despite the interest rates on credit card balances remaining consistently at very high levels. The easy availability of credit via credit cards, increases household debt and spending giving rise to inflationary pressures.

The success with controlling inflation is counter balanced with costs to other sectors, in particular to the manufacturing sector. As the Reserve Bank increases the OCR, there is often an increase in the NZ exchange rate as higher interest rates attract overseas funds. This rise in the exchange rate broadly assists the Reserve Bank in its aims as the Consumer Price Index is reduced with cheaper imports. Manufacturing exports are less competitive and this will eventually result in some reduction in production and employment. This will eventually lead to a negative effect on the balance of payments.

While the OCR appears to work when interest rates are increasing, the evidence that decreases will reflate the economy is less clear as there is no compulsion on lenders to reduce interest rates apart from competition.

Options available to make improvements.

The Reserve Bank has limited options to correct problems and make improvements in the financial system. As mentioned in the opening paragraph, one option that could be considered is for the Reserve Bank intervention to move from the wholesale interest rates, to the retail interest rates and thus have an immediate and direct influence on the economy. This would achieve a separation between the actual market interest rate and the portion that is prescribed by the Reserve Bank.

The charge would be in the form of a percentage levy of the interest rate. In an example a 6% market interest rate with a 10% levy would see  the borrower paying 6.6% to the bank and the bank would pay the .6% to the Inland Revenue Department. The levy would have a similar effect to the OCR on raising interest rates; however the final recipient of the levy amount would change.

Points to be considered in the imposition of a levy.

A very slow introduction would be required, so as to recognise unintended effects at an early stage. The NZ lending institution would be charged with collecting and remitting the levy collected and incurs the costs involved.

In the case of overseas borrowing it is thought there would need to be two levies, one to equalise the interest rates locally with overseas rates, and the local levy paid by the borrower. The local inter borrowing by financial institutions would need to be zero rated to prevent there being a double imposition of the levy. The object of this intervention would be to ensure the same levy applies to any source of funds.

The splitting of interest into its component parts raises the question as to whether the levy imposed by Reserve Bank would be deductible for tax. This requires further investigation.

This proposal raises a question of the recipient of the money collected.

 In the case of an individual, the levy collected could be credited to an individual’s KiwiSaver account. However, the levy collected would need to be invested by the KiwiSaver provider, where it does not immediately re-enter back into the money supply. The levy funds could probably be invested offshore or in long-term Treasury bills or infrastructure projects, so the disposition of funds has a similar affect to the current OCR.

 In the case of a manufacturing company borrowing locally, the proposed levy collected could be credited against company KiwiSaver contributions, or perhaps against company tax, or perhaps as an incentive for Research & Development.

The time delay in crediting would depend on the economic conditions at that time.

 The levy on a finance related company borrowing locally would be zero. However a fund needs to be created to cover defaults by the financial institution. This could take the form of a reserve ratio and be invested in government bonds.

In the case of a company borrowing overseas, we are imposing the levy to try to reduce NZ’s reliance on overseas debt by making such borrowing more expensive.

In the case of government or local government borrowing, it is not clear as to whether the levy paid would be applied, for that matter whether the levy should be collected at all. But if we follow the GST example, having an all-inclusive levy imposed with few exceptions is easier to administer. The use of the levy to retire debt does have some appeal but care would need to be exercised so we are not exacerbating a situation we are trying to correct.

Some of the advantages

This scheme would appear to reduce the problem of inflated interest rates forcing up the exchange rate. The differentiation between the interest element and the levy will make NZ currency a less favourable investment because the overseas lender receives only the market interest, not a figure inflated by the levy.

The additional funds invested in KiwiSaver should alleviate to some extent the reliance on overseas borrowing.

The levy would directly increase the interest on credit cards, which should eventually reduce consumer spending and borrowing when there are inflationary pressures.

Overseas borrowing

The major risk to our economy is the level of total overseas debt in relation to GDP.

The New Zealand economy is vulnerable to an event similar to the Christchurch earthquake or any disease outbreak which affects our farming industry. It seems to me that having systems in place to reduce risk would be a prudent policy to follow.

New Zealand has little or no influence on the global financial system because of our size. However major trading nations have a significant effect on our economy. One of the effects of China holding its exchange rate at an understated value and printing vast amounts of Yuan (Renminbi), is China has a vast amount to invest in US dollar treasury bills which has forced US interest rates to very low levels. Also the US treasury has had a sustained period of “Quantitative Easing” where money is printed putting downward pressure on the US dollar.

Our interest rates and relatively stable exchange rate make the New Zealand dollar relatively attractive to investors wanting investments in the two to three year range. This is reflected in the high US$/NZ$ exchange rate.

The free market advocates will say that the market will look after the problem of overseas debt. However on the face of it; this does not seem to be the case because our economy is distorted by many outside influences.

As can be seen from the European example, the interdependence of financial institutions means they seem to fall like a pack of cards in a crisis and the government and citizens are left with solving the problem left behind.

It seems quite draconian to implement some sort of interest rate levies on overseas borrowing. However one solution would seem to be to increase the price of overseas borrowing and reflect this in the interest rate paid in New Zealand. This solution would seem to be at odds with the policies of attracting overseas investment. It seems to me that we need to attract overseas investment in the areas that create potential export markets and employment.

 The current financial system allows individuals, the business sector and the Government to borrow overseas at lower rates at some times during the economic cycle than they could get locally. The borrower is making a good financial decision by borrowing at the cheapest rate, when the exchange rate is stable. However, what is good for the individual borrower is not necessarily good for the country as a whole. This can be seen in Europe where the financial markets and credit rating agencies view the level of debt of the country as a whole, and the supply of credit can suddenly be reduced with interest rates being charged become unaffordable.

The European governments reaction to debt problems has been to put austerity measures in place with their associated problems.

At some stages of the economic cycle there seems to be a hidden cost for the country in overseas borrowing which is not reflected in the interest rate. If we had a situation of floating exchange rates throughout the world, the problem may be self-correcting. However this seems to be a very unlikely prospect. There seems to be a need to increase the cost of overseas borrowing so that the true cost of overseas borrowing is reflected and borrowing locally is a more attractive option, hence the need for a levy. The higher rate of interest may increase saving which would be an advantage

How would the levy system work for overseas borrowing?

It is thought, that there would need to be two levies. The first levy would be to equalise the foreign interest rate and second, would be the local levy on the local interest rate.

The equalisation levy rate would be set by the Reserve Bank and would need to be a single fixed percentage rate on the amount borrowed irrespective of the currency denomination of the loan. In order to reduce administration, one payment of the equalisation levy for the period of the loan may need to be payable by the borrowing institution on receipt of the funds.

Equalisation levy collected

It is thought that this would be invested in government bonds. One possibility for using this money would be to stimulate the economy when required by returning the money to the entity originally paying the levy. Another possibility may be to establish a fidelity fund for that institution.

Other considerations

 It is difficult to accurately determine the likely effects of a levy on overseas borrowing as there are a number of competing forces at play. Additional KiwiSaver deposits and lower interest rates for overseas investors would also effect the situation.

It all seems to be rather like a balancing act, but I doubt if it is any different to what happens at the moment.

The major disadvantage of a levy is obviously the cost of administration and the frequent changes in rates. This is mitigated to some extent where the bank is borrowing because there would be no need to track individual items. The bank would need to track individuals borrowing transactions much in the same way withholding tax is tracked on the bank borrowing at the moment.The systems currently running at the IRD should not require substantial modification.

A major unknown is the effect on overseas financial markets and whether banks will accept such a scheme, however in an open economy like ours, the importance of improving our overseas debt position must carry a lot of weight in any argument.

There are obviously problems in defining a financial institutions and non-financial institutions and these interpretations are key elements in the scheme.

It would seem unlikely for a scheme to work without it having universal application to all interest rates.

Conclusion

On the face of it a levy system appears to be worth further consideration and investigation to determine the problems and cost versus the benefits of such a scheme. It would appear to be relatively easy to implement and works around the problem of the levy being regarded as tax.

The challenge is to think of something more effective than our current system and one that reduces the risks to the economy.

New Zealand is vulnerable to what happens in the rest of the world’s credit markets and we need to have mechanisms in place to protect ourselves.

*The author Winston Wade is an accountant with an interest in economics. He can be contacted here.